A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

EXERCISE 5: MAKE SURE THE
SHOE FITS: UNDERSTAND YOUR

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INVESTMENT OBJECTIVES
Determining clear goals is a part of the investment process
that too many people skip, with disastrous results. You must
decide at the outset what degree of risk you are willing to
assume and what kinds of investments are most suitable to
your tax bracket. The securities markets are like a large
restaurant with a variety of menu choices suitable for
different tastes and needs. Just as there is no one food that is
best for everyone, so there is no one investment that is best
for all investors.
We would all like to double our capital overnight, but how
many of us can afford to see half our capital disintegrate just
as quickly? J. P. Morgan once had a friend who was so
worried about his stock holdings that he could not sleep at
night. The friend asked, “What should I do about my
stocks?” Morgan replied, “Sell down to the sleeping point.”
He wasn’t kidding. Every investor must decide the trade-off
he or she is willing to make between eating well and sleeping
well. The decision is up to you. High investment rewards can
be achieved only at the cost of substantial risk-taking. This
has been one of the fundamental lessons of this book. So
what’s your sleeping point? Finding the answer to this

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question is one of the most important investment steps you
must take.
To help raise your investment consciousness, I’ve
prepared a sleeping scale on investment risk (see 
The Sleeping
Scale of Major Investments
) and expected rate of return, as of
the early part of the twenty-first century. At the stultifying
end of the spectrum are a variety of short-term investments
such as bank accounts and money-market funds. If this is
your sleeping point, you’ll be interested in the information on
these kinds of investments in Exercise 3.
Treasury inflation-protection securities (TIPS) come next
in the safety scale. These bonds promise a low guaranteed
rate that is augmented each year by the rate of increase of the
consumer price index. Because they are long-term bonds, they
can fluctuate in price with changes in real interest rates
(stated interest rates reduced by the rate of inflation). But if
held to maturity, they are guaranteed to preserve real
purchasing power. In Exercise 7, I’ll discuss the advantages of
having a small portion of your portfolio invested in these
bonds.
Corporate bonds are somewhat riskier, and some dreams
will start intruding into your sleep pattern if you choose this

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form of investment. Should you sell before then, your return
will depend on the level of interest rates at the time of sale. If
interest rates rise, your bonds will fall to a price that makes
their yield competitive with new bonds offering a higher
stated interest rate. Your capital loss could be enough to eat
up a whole year’s interest—or even more. On the other hand,
if interest rates fall, the price of your bonds will rise. If you
sell prior to maturity, your actual yearly return could vary
considerably, and that is why bonds are riskier than short-
term instruments, which carry almost no risk of principal
fluctuation. Generally, the longer a bond’s term to maturity,
the greater the risk and the greater the resulting yield.
*
You
will find some useful information on how to buy bonds in
Exercise 7.

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No one can say for sure what the returns on common
stocks will be. But the stock market, as Oskar Morgenstern

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once observed, is like a gambling casino where the odds are
rigged in favor of the players. Although stock prices do
plummet, as they did so disastrously in the early 2000s and
in 2007, the overall return during the entire twentieth century
was about 9 percent per year, including both dividends and
capital gains. I believe that a portfolio of domestic common
stocks will have a 7 to 8½ percent return, reasonably close to
the annual rates of return during the twentieth century.
Comparable returns are likely from the major companies in
developed foreign markets. The actual yearly return in the
future can and probably will deviate substantially from this
target—in down years you may lose as much as 25 percent or
more. Can you stand the sleepless nights in the bad years?
How about dreams in full color with quadraphonic sound?
You may want to choose a portfolio of somewhat riskier
(more volatile) stocks, like those in aggressive smaller-
company mutual funds. These are the stocks in younger
companies in newer technologies, where the promise of
greater growth exists. Such companies are likely to be more
volatile, and these issues can easily lose half of their value in a
bad market year. But your average future rate of return for
the twenty-first century could be 8 to 9 percent per year.

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Portfolios of smaller stocks have tended to outperform the
market averages by small amounts. If you have no trouble
sleeping during bear markets, and if you have the staying
power to stick with your investments, an aggressive
common-stock portfolio may be just right for you. Even
greater returns, as well as greater market swings, are likely
from portfolios of stocks from many emerging markets such
as China, India, and Brazil that have tremendous growth
potential in the twenty-first century.
Commercial real estate has been an unattainable investment
for many individuals. Nevertheless, the returns from real
estate have been quite generous, similar to those from
common stocks. I’ll argue in Exercise 6 that individuals who
can afford to buy their own homes are well advised to do so.
I’ll also show that it is much easier today for individuals to
invest in commercial real estate. I believe that real estate
investment trusts (REITs) deserve a position in a well-
diversified investment portfolio.
I realize that my table slights gold and omits art objects,
venture capital, hedge funds, commodities, and other more
exotic investment possibilities. Many of these have done
very well and can serve a useful role in balancing a well-

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diversified portfolio of paper assets. Because of their
substantial risk, and thus extreme volatility, it is impossible
to predict their rates of return; Exercise 8 reviews them in
greater detail.
In all likelihood, your sleeping point will be greatly
influenced by the way a loss would affect your financial
survival. That is why the typical “widow in ill health” is
often viewed in investment texts as unable to take on much
risk. The widow has neither the life expectancy nor the
ability to earn, outside her portfolio, the income she would
need to recoup losses. Any loss of capital and income will
immediately affect her standard of living. At the other end of
the spectrum is the “aggressive young business-woman.” She
has both the life expectancy and the earning power to
maintain her standard of living in the face of any financial
loss. Your stage in the “life cycle” is so important that I have
devoted a special chapter (chapter 14) to this determinant of
how much risk is appropriate for you.
In addition, your psychological makeup will influence the
degree of risk you should assume. One investment adviser
suggests that you consider what kind of Monopoly player
you once were (or still are). Were you a plunger? Did you

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construct hotels on Board-walk and Park Place? True, the
other players seldom landed on your property, but when
they did, you could win the whole game in one fell swoop. Or
did you prefer the steadier but moderate income from the
orange monopoly of St. James Place, Tennessee Avenue, and
New York Avenue? The answers to these questions may give
you some insight into your psychological makeup with
respect to investing. It is critical that you understand
yourself. Perhaps the most important question to ask
yourself is how you felt during a period of sharply declining
stock markets. If you became physically ill and even sold out
all your stocks rather than staying the course with a
diversified investment program, then a heavy exposure of
common stocks is not for you.
A second key step is to review how much of your
investment return goes to Uncle Sam and how much current
income you need. Check last year’s income tax form (1040)
and the taxable income you reported for the year. For those in
a high marginal tax bracket (the rate paid on the last dollar of
income), there is a substantial tax advantage from municipal
(tax-exempt) bonds. If you are in a high tax bracket, with little
need for current income, you will prefer bonds that are tax-

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exempt and stocks that have low dividend yields but promise
long-term capital gains (on which taxes do not have to be paid
until gains are realized—perhaps never, if the stocks are part
of a bequest). On the other hand, if you are in a low tax
bracket and need high current income, you should prefer
taxable bonds and high-dividend-paying common stocks so
that you don’t have to incur the transactions charges involved
in selling off shares periodically to meet income needs.
The two steps in this exercise—finding your risk level, and
identifying your tax bracket and income needs—seem
obvious. But it is incredible how many people go astray by
mismatching the types of securities they buy with their risk
tolerance and their income and tax needs. The confusion of
priorities so often displayed by investors is not unlike that
exhibited by a young woman whose saga was recently written
up in a London newspaper: